Raspberry


The Grand Bargain on Greece that was struck last week provoked a skeptical (if not a downright queasy) reaction in many quarters. I wrote about my own misgivings on Thursday. Over the weekend, I saw George Soros was giving the deal “one day to three months” before it failed. What was remarkable, in fact, was how widespread the skepticism was. Who says investors don’t learn? They just learn slowly! The first “rescue package” announcements were greeted with genuine, warm huzzahs. The next wave was welcomed with generous applause. The next round got a smattering of polite applause, and some audience members shifted nervously in their seats. The GBG provoked loud raspberries and the hurling of rotten fruit.

As it turns out, some of those critiques was from the Greeks themselves. On Monday, Greek Prime Minister Papandreou called a public vote to ratify or reject the deal. This offended the rest of Europe, and in particular the politicians who had just run roughshod over the will of their own electorate, who seemed to think Papandreou’s move as analogous to the group of children on Christmas who gather together to discuss whether to return their gifts as being not sufficiently generous. In this case, though, the children are being asked to have a painful surgery before they get some pretty meager gifts, so it isn’t that surprising to me. As many people have pointed out, a 50% reduction in the NPV of debt held by one group of creditors amounts to very little. (It is important to note that the deal probably does not reduce the face amount of debt. If you’re not in fixed-income, that may sound like a niggling detail, and that’s what the politicians were counting on. But for example, if you reschedule a $1 payment due in 1 year to occur instead in 8 years, and the interest rate you apply is 10%, then the first payment is worth 1/(1+.1)^1 = $0.91 and the second is worth 1/(1+0.1)^8 = $0.47, and you’ve cut the present value of the payment almost in half. And it should be noted that no investor is currently willing to lend to Greece at anything close to 10%, which is why the Greek 5-year still yields 27% after the GBG.)

So incensed was French President Sarkozy that he said something truly ridiculous. He said “The plan adopted unanimously by the 17 members of the euro area last Thursday is the only possible way to resolve the problem of Greek debt.” I don’t know about you, but I can think of at least one other way, and I’ll bet the Greeks can as well. “Monsieur, suppose we decide not to pay you? Then it seems to me that resolves our problem. For you, however, this is not so good.” Is Sarkozy trying to provoke Greece with such silliness? If this were the National Football League, President Sarkozy’s comments would be considered “bulletin board material,” meant to inflame his opposition.

Other commentators can tell you better what the odds are that the referendum gives a thumbs-down. But I take issue with the ones who think this is just posturing by Papandreou. That doesn’t make any sense at all to me. For what purpose would the Prime Minister be posturing? He is very likely about to be cast out of the government by his own party. If the referendum is a thumbs-up, he has exactly the same deal he already had without the referendum. If the referendum is thumbs-down, he will be booted out of the government. I think it makes much more sense to recognize that Papandreou is likely going to be booted from his perch no matter what the outcome (it will just change who does the booting), and by putting the measure to a vote a thumbs-up enables him to say that at the end he was only doing what responsible Greeks wanted him to do, while a thumbs-down allows the voters to express their will and not, therefore, vent their rage on the soon-to-be-ex Prime Minister.

Just last week, I was commenting to a colleague that what I found most amazing about this entire saga was that none of these ordinary people who are negotiating these things has actually broken under the strain and done something silly. Merkel, Sarkozy, Papandreou, and others do represent their people but they are also individuals who can say dumb things, make bad deals, and occasionally have a public tantrum that damages the whole process (like, for example, Sarkozy’s tantrum today). Papandreou called for a referendum as a complete surprise to just about everyone – and that’s also the action of an individual; whether it turns out to be a rational one or not depends on Papandreou’s personal preferences and we can’t see those. But an announcement sprung on the world is the sort of stochastic event that can cause a big avalanche, but can’t be proactively planned for.

Well, the other part of the GBG was the structuring of the deal to get around any notion that it qualified as a default under a CDS contract. On Bloomberg TV yesterday, some analyst (I didn’t get his name) made the observation that Pete Tchir has also made recently: if sovereign CDS are no longer protection, then the rational thing to do if you are hedging bonds with CDS is to sell both the protection, and the bonds. One result has been that Italian yields have shot up above 6% at the 5-year point, which represents the highs for the crisis (see Chart).

Destroy the CDS market and investors can only sell the bonds themselves.

As we all know by now, the bankruptcy of MF Global on Monday was provoked, in part, by bad positions on peripheral European sovereign bonds, including Italy. In other words, we can draw a plausible connection between the Grand Bargain on Greece and the failure of MF Global. How come even when Europe screws up, it’s a US firm that fails?!

The MF Global saga initially sounded like another Bear Stearns. A firm with a concentrated position in a particular part of the market (Bear because mortgages was what they did well; MF because Corzine felt like playing in Italy today) took a large hit to capital and lost credit lines and cash quickly. But today we heard that MF Global was not in compliance with customer segregation requirements. This is an incredibly basic rule that is an important part of how a prime broker operates. My money and Fred’s money are kept separate, and separate from the bank’s money (as recently as the mid-2000s, some non-US banks did not segregate customer funds, but I haven’t seen prime brokerage documents recently. Folks, it’s worth checking). My questions here are the same as everyone else’s. (1) Where is the money now? (2) Where the heck were the regulators, since this is a very easy thing to check! And (3) who is going to jail?

I have been a vociferous defender of the part of Wall Street that is run efficiently, that serves an important capital markets function, and that treats customers with honesty and respect. I must admit, that argument gets more difficult to advance and more implausible on its face every time I look around. I know there are good people there, because I’ve worked with them. I just hope those people aren’t thrown out with the bathwater.

Oh yes, market reaction. This week has had a bad start for stocks, while the bond market rally has shredded my short position. While CNBC was busy talking today about a “perfect storm for commodities,” stocks on Monday and Tuesday merely retraced 38% of the entire October rally. Yes, commodity indices were off some 1.5% today…but stocks were down 2.8%. (Yes, this is the channel that refers to a one-tick bounce by saying “stocks are off the lows,” but a 20% drop from the highs of the day is “stocks remain near the highs,” so the misdirection isn’t very surprising.)

The dollar’s strength contributed to some weakness in commodities, but the dollar strength was partly flight-to-quality but no small part the result of massive intervention by the Bank of Japan, who sold roughly ¥8 trillion (roughly $100bln) to restrain the yen. This is where commodities and inflation-linked bond investors will want to pay attention. That sort of intervention size makes it unlikely, although not impossible, that the BOJ will sterilize the sale of yen by selling bonds in the open market (by selling bonds, the central bank absorbs currency that they put into circulation through foreign-exchange intervention). If they do not, then this is akin to what the Swiss National Bank did back in August when they promised to print unlimited amounts of CHF to stem its appreciation. That’s flooding the market with currency, and that’s printing money pure and simple.

This is why TIPS rallied 10bps today versus 12bps for nominal bonds. This says that the decline in nominal yields was 10/12 due to a decline in growth expectations (represented by real rates) and only 2/12 by a decline in inflation expectations. We have TIPS representing good value against nominal bonds, but negative real yields indicate that they are only good value against something like nominal bonds that are even more overvalued. Low real yields (not to mention a broadening roster of money-printing central banks) continue to argue for hefty weights in commodity indices.

Speaking of the growing roster of money-printing central banks, the Federal Reserve started their meeting today in the middle of all of this and tomorrow around 12:30ET will release the carefully-crafted statement that Bernanke will moot when he speaks at 2:15ET.

There is some faint noise about the Federal Reserve giving a nod to the so-called “Evans Rule,” which essentially adds a ‘growth/inflation balance preference’ variable to Taylor-Rule prescriptions when considering the optimal policy rate. It is very unlikely that they do so, mostly because it is far too academic to be included in any kind of statement and far too formulaic for the Fed to consider it a useful policy tool. The FOMC would first have to debate on what the value of the variable should be: how much should policy be tilted towards growth, as opposed to restraining inflation? (And this ignores the main problem, which is that monetary policy doesn’t really affect growth very much unless consumers and investors are subject to money illusion, so monetary policy can only really affect one variable). There is a remote chance of a coarse version of the Evans Rule being implemented, one which says “the Fed will keep rates at zero and tolerate 3% (or 4%) annual inflation until unemployment is down to 7% (or 6%?).” One might argue that the current construction of the statement (promising ‘2 years of zero’) is a step in that direction. But I think it’s the only step they’re likely to take.

If they do take such a step, though, it is an unmitigated disaster for monetary policy and a sign to grab every real investment in sight. Because allowing 3% or 4% inflation has nothing to do with the Unemployment Rate, and moreover there is no sign that the Fed has anything like the kind of power they would need to lock the inflation rate at any particular level. Such a statement would mark a surrender against inflation in order to make a Quixotic charge on unemployment. If the world’s largest central bank goes that route, then bill-printers of the world unite! You have nothing to lose but your change.

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  1. usikpa
    November 2, 2011 at 5:45 am

    Michael, could you comment on the recently released flat core PCE, lower Michigan consumer inflation expectations and crashed PMI prices paid index? Does it change anything in your view?

    • November 2, 2011 at 5:57 am

      I have to answer quickly as I am running out the door: PMI Prices-Paid tracks energy very closely and doesn’t lead actual inflation. Consumer inflation expectations are also entirely trailing in nature (econometrically speaking). Not sure on core PCE, but probably reflecting the same shorter-term effect that drove core CPI lower (they share many elements) in the most recent report. Nothing in these things threatens my thesis – but there will be wiggles, especially in headline.

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